Problems with Using Standard Deviation

Problems with Using Standard Deviation

🔥NEW Standard deviation is the most widely used measure of investment risk. It assumes all investors agree on the degree of risk in every investment.

However there are major concerns or drawbacks of using standard deviation (as single-parameter risk measures) to base investment decisions on:

1. Firstly, investors tend to have different goals when making an investment plan. Some people are risk takers who want to get better return than in the markets on average and some people don't want to take any risk at all. Moreover, investor’s age and wealth dictate different perceptions of the degree of risk in a given investment (Riddles, 2001).
2. A second drawback of standard deviation is the underlying data. If the data is not normally distributed then the standard deviation is likely to give misleading results. “A number of studies have demonstrated that investment returns are not normally distributed”. Hence, in the case of not normally distributed returns, investor using standard deviation as a risk measure is likely to reach wrong results (Riddles, 2001).
3. Moreover, standard deviation, which assumes normally distributed returns, does not take into account Skewness. If the Skewness is negative, it indicates that a return distribution has a tail extending towards values that are more negative. For positive Skewness, the impact is the opposite. (Rogers & Van Dyke, 2006). For example, in this study funds’ logarithm returns were more or less negatively skewed every year.

References:
1. Riddles, N.E. (2001), "A portfolio manager's view of downside risk".
2. Rogers, Douglas & Dyke, Christopher (2006), "Measuring the Volatility of Hedge Fund Returns". The Journal of Wealth Management 9. 45-53, 10.3905/jwm.2006.628683.